Iceland Is Uncomfortable With Krona Weakness, Gudmundsson Says

Omar R. Valdimarsson

January 14, 2013 — 3:00 AM EST

Iceland’s central bank is concerned about the krona’s current weakness as inflation overshoots its target, Sedlabanki Governor Mar Gudmundsson said.

“It’s not comfortable to let the krona be this weak considering that inflation is still above the target and wage agreements in the labor market are open” for renegotiations, he said in a Jan. 11 phone interview.

The currency closed last week at the lowest level against the euro since in almost three years as the nation struggles with an overhang of foreign currency debt. The bank last month kept its benchmark rate unchanged, citing a stable krona, after six increases since August 2011 to cool inflation as the nation emerges from its 2008 economic collapse.

Policy makers are trying to steer Iceland’s recovery four years after its banking meltdown plunged the nation into its worst recession in six decades. Iceland, which completed a 33-month International Monetary Fund program in August 2011, is now outgrowing much of Europe. The central bank’s main focus has turned to unwinding capital controls enforced at the end of 2008, without putting pressure on the exchange rate.

Currency restrictions are blocking as much as $8 billion in offshore krona assets from being sold, according to estimates by Arion Banki hf.

The bank is seeking “much more than anything else” to reduce “excessive fluctuations” in the krona, Gudmundsson said.

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“We know why the exchange rate is as weak as it is,” he said. “It’s due to domestic parties paying down their foreign loans, which they’ve been unable to refinance in the foreign market. Therefore they have to exchange their kronur into foreign exchange, for this purpose. This can be mended by trying to assist these parties -- and the banks in general -- in gaining access to the international debt markets.”

The krona has lost 16 percent against the euro since an Aug. 10 high. Inflation was 4.2 percent in December, surpassing the bank’s 2.5 percent target.

The krona slid 0.4 percent to 171.08 per euro on Jan. 11, the weakest closing level since April 26, 2010. The currency traded at about 230 per euro offshore, according to Keldan.com, a website run by Reykjavik-based H.F. Securities hf.

Preparation Work

While it will take time to abolish capital controls, the bank is continuing on “various preparation work,” Gudmundsson said. The Treasury should make preparations so it doesn’t need domestic financing from 2014, “since removal of capital controls will cause an increase in the domestic cost of financing,” he said.

The bank will also continue to reduce the “overhang” of foreign currency through auctions and can continue working on setting up an exit tax and develop the rules that are required around the operations of financial undertakings, in order to ensure that they won’t go “bankrupt immediately,” he said.

The bank in November estimated that inflation will average 3.6 percent this year and slow to 2.7 percent in 2014. Gross domestic product will expand 2.5 percent in 2012, 2.9 percent this year and 3.5 percent in 2014, it said. The economy of the euro area is estimated to have contracted 0.4 percent last year, the European Commission said on Nov. 7.

The bank this month halted foreign currency purchases, which totaled a net 20 billion kronur last year, according to the governor.

“So we’re taking a lot into the reserves, which would have yielded a stronger krona had we not done this,” he said. “Now we’ve stopped doing that, as the krona is now very inexpensive and the foreign exchange is expensive. And if possible, one should avoid purchasing foreign exchange when it’s expensive.”